HOW INTERNAL CONTROLS HELP CONSTRUCTION CONTRACTORS

GREGORY P. DESTEFANO AND JAMES MILLER GREGORY P. DESTEFANO is a partner in the Assurance Services division of Marcum LLP's New Haven, Connecticut office. He has more than 25 years of experience conducting, reviewing, and analyzing financial information for a variety of clients. As a member of the National Construction Industry Group, Mr. DeStefano specializes in the industry's unique accounting needs. He has helped construction clients with profitability enhancement, implementing job costing systems, succession planning, and claims. He also has a variety of Homebuilder and Real Estate Development clients who look to him for job cost assistance. JAMES MILLER is an integral member of Marcum LLP's National Construction Industry group and is located in its New Haven office. He has more than ten years' experience conducting, reviewing, and analyzing financial information for construction contractors, not-for-profit organizations, manufacturers, and service corporations. Mr. Miller has also been involved in high profile and sensitive engagements regarding fraud and litigation support. A sought-after speaker on accounting and auditing matters for construction issues, Mr. Miller has conducted internal training seminars and has presented on issues and updates regarding the construction industry and construction engagements. A strong system of internal controls allows contractors to combat common risks in an uncertain economy. The construction industry continues to be a risky business, struggling to grow under weak demand and budget constraints. Contractors face an economy with lower gross profit margins, increased customer concentrations, challenges in collecting receivables, and more competition. Even successful contractors are facing greater losses and poor performance. Unlike other industries that just have a banker or a stockholder relying on their financial statements, a contractor has many more users the surety/bonding industry, regulatory boards, creditors, and customer/owners. The banking and bonding industry has tightened its belt, making it far more difficult to enter into lending and bonding programs to help fund and protect contracts. So what can contractors do to gain a better position today?

While a contractor cannot predict the economy, internal results can be controlled. The main reasons contractors experience poor performances are: inadequate estimating; employee theft/dishonesty; poor site conditions; unapproved change orders; material price increases; and labor overruns.

How can contractors prevent these risks? A strong system of internal controls procedures or systems designed to promote efficiency and integrity of financial and accounting information, meet operational and profitability targets, and prevent and detect the occurrence of a misappropriation of company assets. A challenge above the rest Designing and evaluating a contractor's internal control system is more difficult than in other types of businesses. This is because contractors have to provide fixed prices for delivery of a final product that they do not, in most cases, design. Contractors' actual operations also occur at remote job sites away from corporate headquarters and management oversight. Most contractors do not maintain a separate internal audit function, so the responsibility for the development and maintenance of an internal controls system falls within the role of the controller or chief financial officer. Regardless of industry or business, there are a number of questions to address when evaluating and designing internal control systems. Has management created an environment in which effective controls can be implemented and operated? Does the company operate an accounting system providing assurance that all transactions are recorded properly? Is there adequate segregation between the operations of the enterprise and control over recording of information and assets? Do adequate checks and balances exist and operate?

No business especially smaller businesses can afford the cost of a perfect internal control environment. A balance will always exist between the level of risk and the cost to implement and operate effective internal controls. Beyond the traditional control areas of most businesses that contractors must contend with, there are unique controls specific to a contractor's operations: estimating and bidding; project administration and monitoring; job site accounting and controls; and administration of change orders and job costs.

Estimating and bidding Contractors can fail to recognize the critical importance of contract estimates. Controlled estimating and bidding are necessary to provide adequate documentation, clerical verification, overall review of estimated costs, and approval of all bids by management. Controls also must take into account factors that will affect the cost, revenue, and profitability of each contract. Unreliable estimates can obscure losses on contracts in their early stages or can affect the estimated profitability of contracts, eliminating the reliance on estimates from third-party bank and bonding companies. Estimators rely on information from past construction projects to produce useful estimates for future work. Examples of control activities related to estimating and bidding include: assigning a manager to review general contract cost estimates based on specifications, plans, and drawings, making comparisons with actual contract estimates; reviewing bid estimates for inclusion of proper amounts or percentage markup for internally allocated or generated costs such as labor burden percentages, equipment rates, overhead, executive salaries, etc.; verifying clerical accuracy of final contract estimates; reviewing contract specifications, plans, and drawings and documenting critical items in the bid analysis; evaluating subcontractors for prior performance creditworthiness and bonding requirements or capability; obtaining at least two independent estimates internally on complex or large contracts;

establishing procedures to eliminate undocumented adjustments to estimated costs; comparing and relating estimated material costs to published vendor price lists, price quotations, subcontractors' bids, and other supporting documentation;

comparing and relating estimated labor rates to union contracts and other documentation supporting labor rates, payroll taxes, and fringe benefits;

comparing and relating estimated equipment costs to the rates charged by suppliers for rental or used by the contractor to allocate the cost of owned equipment to jobs;

considering the effects of potential cost increases during the period of the contract, including historical trends; and

reviewing all bids and confirming authorization signatures are on the bid approval form.

Project administration and monitoring The ability of a construction contractor's personnel to manage the actual construction process is probably the single most important factor in determining the profitability of individual jobs and operations as a whole. During the life of the contract, it is important that controls are in place to monitor the results and performance of each. Normally this includes reviewing a comparison of the detailed actual contract costs to the current estimate of costs to complete all phases of the project. Details of the original estimate and the total contract price should also be addressed, immediately identifying contract fades, which occur when a contract's gross profit is adjusted downward from a previously reported estimate. Sureties and other readers of contractors' financial statements closely monitor historic contract results and contract fades as a method of predicting future contract profitability. Monitoring the estimate of contract costs in a consistent manner will permit subsequent detailed comparison of actual costs with estimated costs. Examples of control activities related to monitoring contract estimates include: maintaining all activities, meetings, and job progress in a daily log; developing a project schedule at the preplanning stage and maintaining changes throughout the project; assigning personnel to regularly perform monitoring procedures, preparing job progress reports to update the status of the job (this can include a review of potential claims, cost to date, cost to complete projections, and job profitability forecasts), and setting periodic meetings with management and project managers to discuss results;

reviewing the quantities of material and labor hours in the bid estimate and comparing them to the customer's specifications;

paying subcontractors only on the basis of work performed; obtaining performance bonds; adequately documenting each subcontractor requisition and reconciling work performed to the subcontractor's requisitions and schedules of values;

ensuring that all materials and nonsubcontract purchases are supported with approval, prenumbered purchase orders that indicate the quantities, price terms, and delivery dates for all purchases;

putting in place a documented system requiring all purchases be supported with bids or proposals from three qualified bidders;

setting up a detailed cost-coding accounting system to track costs in three separate categories: type of cost (e.g., labor, materials, subcontractors, etc.), work-type cost (e.g., mechanical, concrete, electrical, etc.), and individual system cost (e.g., piping, duct work, location, etc.); and

maintaining current estimates updated by project management and engineers.

Job site controls Establishing adequate controls for numerous remote offices may be difficult but isn't any different than the controls implemented at the contractor's main accounting location. Some aspects relating to the nature of the remote location of jobs that should be included in any evaluation of controls include: (1) procedures for proper authorization for purchases and control over deliveries, (2) physical control over equipment and materials and supplies on the job site, and (3) communications among the various parties including between the job site and the home office. Changes in job site conditions will always require an update to contract profitability. Consider the following. 1. Management should review job site controls in order to ensure their operation is in accordance with the procedures established by the contractor. 2. Monitor on-site logs for each subcontractor with the contract, correspondence, changes, and payment requisitions. 3. Maintain a log of all small tools and equipment used on site, the location, and assigned responsible person. 4. Establish on-site payroll procedures including:

approval of all timesheets by a supervisor; review of all cost coding for time charges; approval of overtime on an exception basis; distribution of payroll checks directly to employees by an individual not responsible for payroll approval; and

approval of new employee hires, payroll charges, and terminations.

5. Document job site procedures for management of materials and other nonsubcontracted purchases. Pre-numbered purchase orders are utilized for all purchases including amounts, quantities, and terms. Purchase orders are approved and verified. Materials delivered to job sites are taken to predetermined locations, and all quantities are verified and delivery tickets approved. Material inventories on site are periodically verified by physical count and quantity usage recorded. 6. Document procedures created for recording and tracing the usage of owned or related construction equipment, including: job site usage logs; equipment status reports and repair requests; equipment requisitions with approvals; standard rental agreements; and weekly equipment usage reporting.

Administration of change orders and job costs Change orders. Change orders are modifications to one or more provisions of the original contract. Contract profitability must always be recalculated when a change order has been granted. Unapproved change orders generally should not be booked as revenue until approved, or, if recovery of cost is probable, should only be booked as revenue to the extent of cost (showing zero gross profit). All changes to the scope of work performed not included as part of the original contract are required to be documented in writing, with proper approvals or notice to proceed prior to the work being performed.

A log is maintained for all pending owner change orders and the resolution of each change request.

Change orders should be approved by at least one, if not two, authorized personnel.

Job costs. Accurate job costing for a construction contractor is very important. A contractor uses contract costs to control costs, evaluate the status and profitability of contracts, prepare customer billings, and calculate revenue earned on each project based on the percentage of completion. A cost charged to the wrong contract will not only mislead the user about the contract profitability, but may result in acceleration of revenue recognition and improper incentive payments based on contract results, thereby distorting the financial statement. Contract costs should include direct costs, such as labor, materials, and subcontracts, and should also include indirect costs, such as labor burden, equipment expenses, depreciation, insurance, etc. Control activities around job cost might include the following: comparing and relating the quantities and prices of materials charged to contracts to vendors' invoices, purchase orders, and evidence of receipt of materials; documenting labor charged to contracts by reference to payroll records and related documents (such as time cards, union contracts or pay authorizations); relating subcontract costs charged to contracts to the terms specified in the subcontract agreements and supporting documents; reviewing the accumulation and allocation of indirect costs to contracts; and reviewing contract costs to ensure they are being allocated to the proper contract.

It is important that, once a company invests time and effort into creating an internal control system, the system is maintained. Far too often in small- and mid-sized construction companies, formal control procedures are established with the intention of adhering to them, only to have them overlooked by those involved on a routine basis. If the procedures are not maintained, the system does not provide for adequate control. 2013 Thomson Reuters/RIA. All rights reserved.